We used to have fun commenting about the bond market, including Treasuries, Mortgages, Municipals, and Corporates. But that was before the dark times. Before deleveraging.
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Friday, July 31, 2009

Housing is actually doing better than I thought it would. We have now seen pretty good increases in new home sales, existing home sales, and even the Case Shiller index posted a month-over-month increase.

There is great debate over exactly how good these numbers are. I'm getting a little sick of the term "less bad is good" but it does neatly summarize where we are. In many ways, it depends on what exactly you are trying to analyze. Or put another way, what question are you trying to answer?

When will the recession end?This is basically a question of GDP growth. The 4Q/1Q inventory liquidation will eventually turn into a rebuilding of inventories, which in turn will eventually result in positive GDP. In simple terms, inventories got so low that any sales activity required greater production activity. It isn't that final sales activity is "normal" or "good" but that the economy was set up for lower final demand than we're getting. Keep this theme in mind as we go.

In terms of housing, the direct impact was classically from home construction. Any kind of positive contribution from construction was long ago lost, so I see this as a minor element.

What about consumer spending?The whole mortgage equity withdrawal game is also dead, and has been for a while. This was once a source of consumer spending, and its a source that isn't likely to come back any time soon.

However, the negative equity story remains. Right now, based on Case Shiller, nationwide home prices are approximately where they were in 2003. Most people who bought their homes in mid-2004 or so, and put 10% down are now underwater. Foreclosures and "jingle mail" catch the media's attention, but the reality is that most of these people who are underwater will just keep paying their bills month after month. Most of those same people can afford the payments, but won't be able to afford to actually move out of the place until they have saved a lot more money. Home price appreciation from here won't be enough. So basically we have people saving more and staying in their homes longer.

Therefore I see an elevated savings rate for many years to come. This will be consistent downward pressure on consumer spending, although it wouldn't prevent consumer spending from increasing from one period to the next. Just that each period will be lower than it otherwise would have been.

Have home prices stabilized?All the current trends say yes. Think back on why home prices started to fall in the first place. There was too much supply and not enough demand. In any good, when there is a supply/demand imbalance we'd expect to see a period of low generalized activity as both suppliers and consumers engage in price discovery. This is exactly what happened in housing, as activity plunged along with prices.

Now we're seeing activity pick up. Both new and existing home sales have increased in 4 of the last 5 months, despite interest rates rising during that period. New home sales have risen a total of 17% since January, while existing home sales are us 9%.

Yes, the absolute level of sales is still anemic. I know. But these are numbers which have historically shown long dragged out trends. I believe that once a positive trend is established, these numbers will keep improving.

Besides, its worth noting that the "normal" level of housing transactions needs rethinking. If people are going to stay in their homes longer, then the velocity of housing transactions should be persistently lower.

Regardless, the uptick in activity suggests that buyers and sellers are coming together on prices. I think the fact that Case Shiller has basically been flat the last two months backs that up. This isn't to say homes might not keep falling in some parts of the country, but the nationwide, generalized decline phase is over.

If housing is to take another turn lower, there will need to be some catalyst. I'd think the most likely would be that the Fed is forced to aggressively hike rates. I think that's a low probability event, but possible nonetheless.

All this being said, I don't have any particular reason to believe home prices will rise rapidly from here. It would seem that we'd need an improvement in employment before housing can advance significantly, at least on a national level.

What about the banking system?That's an uglier picture. Home prices can start rising from here, GDP can rise from here, but banks are saddled with all kinds of legacy problems. Home mortgages, developer loans, commercial loans, etc. Some of it directly related to housing, some not. I've already talked about the residential problem: that negative equity is going to take a long time to work off. Not only does that result in larger losses on each mortgage that must be foreclosed, but it means less turnover among their existing mortgage portfolio. Less fees, less cash flow, its a negative all around.

Commercial real estate is a whole other game. I think a lot of commercial real estate securities might be fairly priced, but commercial real estate loan losses are just beginning.

Now I'm not saying the banks are all going down, but I think there are some larger regionals that are in trouble. And as I said with CIT, a lot of them won't be deemed To Big to Fail. Is KeyCorp too big? Fifth Third? Marshall and Ilsley? I don't think so. In fact, I'm not 100% sure that Wells Fargo doesn't need more capital before this is all said and done.

All this comes in context with how well the securities markets are doing. I personally don't have much at all invested in stocks. I don't understand why they've run as much as they have, but I'm also not here to say it ought to crash from here either. I just don't understand it.

I guess my problem is with how the debate is being framed. Things are getting better in the economy. I don't think that's debatable. The debate should be more about the degree and the speed at which things can keep improving. At least, if you are trying to figure out how to make money trading, that's the best question.

Friday, July 24, 2009

I don't understand CIT's new filing. They boosted their offer for anyone delivering by the end of the month, but they also said they "don't intend" to file for bankruptcy if the tender succeeds. That's what's strange to me. Did someone think they did intend to file for bankruptcy? I mean, I'd think they'd only include a statement like that because one or more large bond holders had that concern. We know CIT might wind up having to declare anyway if circumstances go against them. They can't promise they won't have to file. But obviously you only try the tender in an attempt to avoid bankruptcy. Right? Am I missing something here?

Becky Quick and Warren Buffett. BFF or Friends with Benefits?

I can't believe stocks were about flat after Microsoft's ugly report, then fell when consumer confidence came out. Consumer confidence is the most worthless statistic that the media just laps up. Look at what consumers are doing not what they say.

Eurodollar futures showing a Fed hike in January. Not going to happen. This is just like 2001-2002 when everyone thought there would be a hike sometime in the next 3-4 months and it kept never coming. Investors in the belly crushed investors in the front end.

The fact that Treasury's can't catch a bid here with with stocks down over 1% is a pretty bearish sign, especially with heavy supply next week. I also think sentiment around the auctions is more sanguine, setting us up for

Wednesday, July 22, 2009

By my estimation, California actually closed about $15 billion of its $26 billion deficit. Maybe less. Its looks like technically they'll be able to go into the next fiscal year and resume paying their bills (assuming the legislature passes the budget bills), but its obvious this budget involves a lot of pushing the problem into future years. Consider the following:

According to the LA Times, the budget includes $1 billion from sale of the State Compensation Insurance Fund, but that no one thinks such a sale can be accomplished this year.

It takes $1.7 billion from local redevelopment districts, a move that was ruled unconstitutional just last year. According to one district official I talked to, there is nothing materially different about this year's proposal to suggest it wouldn't be struck down again.

The budget also borrows $1.9 billion from local governments. This would need to be paid back.

Another $1.2 billion will be saved by pushing payroll back one day, from June 30 to July 1. Effectively pushing $1.2 billion onto the next year's budget. But its still money out the door.

So right there, we've identified about $6 billion that isn't any kind of long-term solution. Basically I'd argue that California will start next year $6 billion in the hole.

Now ask yourself, will revenues increase?

The answer, even for someone pretty optimistic about economic growth, is clearly no. Consider the three main sources of revenue for California governments: sales taxes, income taxes, and property taxes.

The first thing to realize is that California's tax collections occur over the course of a year. So the money the state has collected for the June 2008-June 2009 fiscal year occurred during a period when the economy was declining. But what that means is that taxes collected in the early months of that period were stronger than those in the later months. For example, here is Advanced Retail Sales (nationwide) for the June '08 to June '09 period.

I drew a red line over the average for the 12-months. One might simplistically say that sales tax collection for the most recent fiscal year was based on this "average" sales level. But will the average from June 2009 to June 2010 be as high? probably not, even if the economy starts to recover. The current reading ($342 billion) is 2.7% below the average level of $352 billion. Of course, in order for the average to rise to $352 billion, the ending number will have to be double that increase, or +5.4%!

Coming out of the 2001 recession, we didn't get a year-over-year increase that strong until 2003, or about 2 years after the recession was over. Even if the recession ends today, its unlikely sales tax collections will even match last year's figures.

Income tax has a similar problem. If we assume income tax is in large part a function of unemployment, then unemployment will have to average 9.3% just to match 2008-2009's revenue figures.

Is California unemployment going to fall from 11.6% to 7% next year? Extremely unlikely. Unemployment is classically a laggard. We are more likely to see unemployment rise from here, even if the recession is almost over.

Property taxes? Same problem. In fact, maybe even worse. Assessments aren't made in real time. Unlike sales tax, for example which evolved over the course of the year, the task of re-assessing properties to reflect the current environment is an on-going thing. And obviously every new assessment is going to be lower than the previous. I've argued before than home prices are going to keep falling, at least statistically, even after the housing market has bottomed. In this piece, I argued that once transactions pick up, it will only prove that prices are in fact lower, thus making the statistical measure of home prices fall all the more. Even though I believe that transactions will show the real bottom of housing, the point is that prices keep falling for some period thereafter. As an aside, I'd think that's all the more true for commercial property, which trades even less frequently than residential property.

So if I claim that California starts out $6 billion in the hole (probably more) because of accounting scum and villainy, that isn't taking into account the near certainty that revenue will fall during the 2009-2010 period. On top of that, I'm assuming revenue will fall even if the recession is over right now. If it isn't over yet... well... I fear the worst.

Monday, July 20, 2009

California's budget woes are getting all the attention, but as reader In Debt We Trust pointed out, Philadelphia is also halting payments to vendors. In fact, because the current recession is hitting property taxes so directly (which is most local governments' best revenue source), I'd expect municipalities to struggle mightily with their budgets for the next couple years.

Now I expect very few actual defaults among municipal governments. But there will be some. And there will be even more close calls. Situations where municipal governments do things that they wouldn't normally contemplate.

Things brings us to some interesting legal questions that might shake the foundation upon which much of the muni market is based. Consider the use of lease-backed transactions. Here is a sample of language from a municipal official statement. Its for a lease by the City of Tulsa for a city government administration building. For full disclosure, I don't currently own this issue, but once did:

"Notwithstanding anything to the contrary contained in the Lease, if the City does not appropriate funds paid to the Authority pursuant to the Lease for any fiscal year... during the term of the Lease, the City shall not be obliged to make payments for such non-appropriated fiscal year. In such event, the Lease shall automatically terminate and become null and void as of the end of the preceding fiscal year."

So you ask yourself, who the hell would buy such a security? Basically Tulsa can get out of this lease by... not paying it! Imagine if an apartment lease was written this way: "The Tenant owes the Owner the rent, except if he doesn't pay the rent."

The answer is, of course, because if the City doesn't pay its rent, then in theory, bondholders can evict them from the administrative building. Obviously the city would still have to fill an administrative function, and if they reneged on one lease, they'd have a hard time getting another one. On top of that, depending on the situation, bond holders may not have the right to foreclose on the building.

Classically, munis guys have considered the essential service nature of any lease back transaction. So for example, this Tulsa deal, bond buyers can take some comfort that the City has a strong incentive to honor their obligation. In fact, in a typical lease-back deal, the ratings agencies will rate the lease 1 notch below the issuer's general obligation rating. So the City of Tulsa is rating Aa2/AA, this deal would be rated Aa3/AA-.

Now let's look at a different deal, this one for a new toll road being built in the Research Triangle area of North Carolina. This one was just sold last week.

"In July 2008, the General Assembly of North Carolina enacted legislation that included a provision creating a continuing annual appropriation to the Authority of $25,000,000 for the Triangle Expressway System to service debt and fund required reserves in connection with bonds issued to finance the Triangle Expressway System... The legislation states that it is the intention of the General Assembly that the enactment of the annual appropriation ... shall not in any manner constitute a pledge of the faith and credit and taxing power of the State of North Carolina, and nothing contained therein shall prohibit the General Assembly from amending the appropriations to decrease or eliminate the amount annually appropriated to the Authority." (Emphasis is in the original.)

So the state is giving you what? Literally just promise. Bond holders do not have a mortgage on the toll road (which isn't even constructed yet). The beneficial rights to that road (tolls) are 100% the State's. Bond holders cannot get to those funds. So in theory, the State could build the road, start collecting tolls, and then repeal the legislation allowing for payment to bond holders!

Now, I don't think this is very likely, since as I said, if the state reneged on its appropriations pledge, then it would be effectively shut out of the capital markets. But its amazing to think that bond holders actually bought up this Triangle Expressway deal without even demanding the proceeds from eventual toll revenue. At least that would give the state some real economic incentive to keep bond holders whole. Needless to say, I passed on these bonds.

But it brings up an array of legal questions, many of which have rarely been tested in court, if ever. For example, as I said before, bond investors have always valued more "essential service" leases over those designed for economic development. But could a municipality legally choose which lease payments to make? For example, (and I'm just making this up) say Tulsa has this lease for an important admin building, but it also built a conference center which it leased back to itself. Maybe the conference center can't get anything other that some dorky Star Wars convention every year and the City's budget is strained enough. They just want to close the place and walk away.

In a normal corporate setting, a corporation can't just choose not to pay subordinate bond holders in favor of senior holders outside of bankruptcy. Sometimes they can defer payments, depending on how the deal was structured, but even there, the obligation doesn't erase.

As I said above, ratings agencies treat these lease deals very much like a subordinate general obligation. But is it really? Getting back to my Tulsa example, if both leases were structured as subordinate GO bonds, then Tulsa would have to treat both the same. They couldn't choose to walk away from the money losing convention center but keep current on the admin building. The only way to restructure their indebtedness, without bond holder approval, would be in bankruptcy court.

But the leases aren't really subordinate GOs, not in a legal sense. But could someone go to court and argue that all Tulsa's leases are pari passu?I don't know that its been tested, and it probably depends very much on how exactly the indenture language is written as well as each state's constitution.

And what about something like the North Carolina highway, where its just a straight state appropriation. Say the state can't afford to make the appropriation in 2016, but the highway is still in use. Then let's say their fiscal situation improves in 2017. Would the state still be obligated to make its appropriation pledge? If they completely walked away, could a court rule that the State can no longer use the road? Again, I don't think this kind of thing has been tested all that much.

And it probably won't be tested with state-wide revenue issues. North Carolina's reputation is worth a lot to them in terms of lower cost of funds. So it would take a pretty bad situation for them to trash their credit rating. But I'm betting there are some local governments who try some aggressive maneuvering to improve their budget situation. And there will be lawsuits. Oh yes, there will be lawsuits.

Friday, July 17, 2009

So the government has found where the "Too Big to Fail" line is, and its CIT. Long-time readers know I was all for bailing out Bear, Lehman, Fannie Mae/Freddie Mac and AIG. I was also all for having the government buy toxic assets. I thought all these things were sensible responses to a very real danger of a economic collapse.

All that being said, there has to be a line, and the line can't be "any firm where there might be pain." That is what we have with CIT. Will it be painful? Yes. CIT is a long-time lender to lots of medium-sized businesses, some of whom might not be able to get other funding. Yes, some of them will wind up going under. But the simple reality is that CIT has been a pretty loose lender for a long time. In fact, I'd argue that CIT was primarily an asset-based lender, meaning that they viewed the collateral asset (e.g., the receivable) as the primary credit factor. Admittedly, I don't know any of CIT's lenders, but just from following the company over the years, that's always been my impression.

In today's world, asset-based lending is all but extinct. Think about it. Its basically the same attitude as the no-doc home mortgage lender. You figure that the house is worth more than the loan, so it doesn't really matter how credit worthy the borrower is. Worst case scenario is that you liquidate your collateral and come out whole.

It isn't that quality collateral can't be a factor in lending, but I really think CIT's model assumes a world of high liquidity. In other words, a world where various pots of money exist to buy up the collateral if need be. This was the domain of certain hedge funds or other alternative asset vehicles at one time. Not any more.

The other problem CIT has is a lack of credible funding source. I use the word "credible" intentionally, because any non-back lender has to be able to prove access to the capital markets, which CIT cannot do. So anyone relying on CIT to fund their business will logically draw down their credit lines, which is exactly what has gotten us to this point. Its about credibility as much as it is about CIT's actual loan portfolio.

Speaking of the loan portfolio, its pretty weak. The Wall Street Journal ran a piece showing how bad their delinquencies are. I don't know this for sure, because I've never owned CIT debt, but I'd bet their delinquencies have always been weaker than the average, just considering their borrower profile. But that's no excuse. The fact is that CIT lends to a lot of businesses that are vulnerable to a deep downturn.

So put this all together, and you have a basic business model: asset-based lender without access to bank funding, that just flat out doesn't fit in today's world. CIT may as well be making type writer ribbons. I'm sorry, it just has to go.

This is the moment were we take the training wheels off the economy. We had to do it at some point. We had to eventually send a message to the world of finance that not everything was going to be bailed out.

How great would it be for CIT to work something out with bond holders? I mean, an actual "normal" deal to avoid bankruptcy? I mean, it would almost be like capitalism is back!

About Me

I oversee taxable bond trading for a small investment management firm. Opinions expressed on this website may not reflect the opinions of my employers. Strategies described here should not be taken as advice, and may not be the strategies being used for my clients. Take this website as the egotistical ramblings of a bond geek and nothing more. E-mail is accruedint *at* gmail.com or find on Facebook.